Taxation of Single-Parent Captives: A Basic Guide
One common captive structure is an insurance company owned by a single US corporation (a "single-parent captive"), which insures the risks of its parent and/or brother/sister companies. In some cases, single-parent captives cover risks of third parties as well as related party risk. The US federal income tax treatment of a single-parent captive and its owner depends in part on whose risk the captive insures and on whether the captive is a US company or a non-US company. This article summarizes the basic tax rules applicable to single-parent captives and their owners in various situations.
If more than 50 percent of a single-parent captive's business is the issuance of contracts that qualify as insurance for federal tax purposes, the captive will be treated as an insurance company and taxed accordingly. In order for a contract to be treated as an insurance policy for federal tax purposes, it must involve insurance risk, shift risk, distribute that risk, and have the attributes of insurance in the commonly accepted sense. (For discussion of these concepts, see "When Are Premiums Paid to a Captive Insurance Company Deductible for Federal Income Tax Purposes?") The Internal Revenue Service (IRS) and the courts have concluded that a parent company cannot shift risk to its captive subsidiary unless the captive also insures significant third-party risk. The IRS safe harbor ruling has a 50 percent threshold for unrelated risk, but case law has found parent risk to be shifted if the captive subsidiary has as little as 30 percent third-party risk.
Under the analysis of the Humana case, a brother/sister company can shift risk to a single-parent captive even if the captive does not cover any third-party risk. Thus, if more than 50 percent of a single-parent captive's business is brother/sister business that otherwise meets the test for insurance treatment, the captive will be treated as an insurance company for US tax purposes even if 49 percent of the business involves coverage of the parent company. However, the parent company coverage will not be treated as insurance.
A US single-parent captive that qualifies as an insurance company is taxable under Subchapter L of the Internal Revenue Code of 1986, as amended (the “Code”). Generally, a US property and casualty (P&C) insurance company reports premium income as earned and deducts losses as incurred. Accordingly, a P&C company has reserves for unearned premiums and unpaid losses. Increases in those reserves are deductible, and decreases in the reserves are reportable as income. The starting point for determining the amounts included in reserves is the P&C company's statutory accounting statements. However, the amount of tax reserves varies from book reserves because loss reserves are subject to discounting to adjust for the time value of money, and unearned premium reserves are reduced by 20 percent as a proxy for deferred acquisition costs. In addition, the IRS has successfully challenged reserve amounts when the development of the reserve amount is not consistent with statutory accounting rules. Ordinarily, noninsurance items, including investment income, are reported in accordance with the general tax rules for accrual-basis taxpayers. Even if a single-parent captive qualifies as an insurance company, the premiums and losses arising out of any policies it issues that do not meet the test for insurance treatment would be excluded from the company’s reserves. The tax treatment of such policies would be the same as the tax treatment of policies issued by a US single-parent captive that does not qualify as an insurance company. In the context of a consolidated group, the net tax benefit to the group for a year will generally be the reserve deduction (i.e., the net change in reserves) that the single-parent captive is allowed because, although the group members may take a deduction for premiums paid for insurance characterized as such for tax purposes, the captive would have a corresponding income item.
If 50 percent or more of the policies issued by a single-parent captive do not meet the test for insurance discussed above, the captive would not qualify as an insurance company for US federal tax purposes. A US single-parent captive that does not qualify as an insurance company would be taxable under the normal rules for accrual-basis taxpayers and would not be entitled to deductions for increases in unearned premium and unpaid loss reserves. The key question for such captives is how their insurance policies should be reported for US federal income tax purposes. The authorities do not provide clear guidance on this point. However, commonly, those policies are viewed as deposit arrangements or loans, with the premium treated as a deposit or the principal amount on the loan and the loss payments treated as repayments of the loan. Under this approach, the captive would have no income from the premium payment and no deduction from the loss payment, except to the extent some portion of the loss payment may be recharacterized as a payment of interest on the loan.
Deposit treatment is particularly appropriate if the policy in question can be expected to produce loss payments that roughly equal the premium amount plus a market interest rate. If the coverage is more volatile, the insurance policies may look less like a deposit or loan. In that circumstance, the payments under the policies may be viewed as capital contributions and distributions, especially if the premium payment is coming from the captive's parent. Under this approach, the premium payment would be treated as a capital contribution, and any loss payments would be treated as distributions, which would be dividend payments (eligible for the dividends received deduction) to the extent of the captive's earnings and profits, if any. This treatment would be hard to justify, however, if insurance coverage is provided to brother/sister companies or third parties.
It also is possible that the IRS would take the position that an insurance policy that does not qualify as insurance for federal tax purposes should be treated as a service arrangement. In that circumstance, generally, premiums would be taxable when accrued, and losses would be deductible when paid. The IRS has taken this position when it argues that insurance arrangements between unrelated persons do not qualify as insurance for federal tax purposes but not when such arrangements involve related parties.
A non-US single-parent captive is not subject to net basis taxation in the United States1 unless it is engaged in a trade or business in the United States2 or elects to be treated as a US insurance company.3 However, under the Subpart F provisions of the Code, the US owner of a single-parent captive will be taxable on the net underwriting and investment income of the captive to the extent of the captive's earnings and profits, even if the captive does not distribute that income. Whether the non-US single-parent captive qualifies as an insurance company or does not, it generally would compute its net underwriting and investment income under the Subchapter L rules for US companies explained above. To the extent the non-US captive issues policies that do not qualify as insurance for US federal tax purposes, the captive's income from those policies generally would not be included in computing Subpart F income because it would not be treated as underwriting income, nor would it fit the definition of any other type of Subpart F income.
The US tax rules related to insurance companies are complex, and this article provides only a summary of those rules. However, it should provide a good starting point for determining how a particular single-parent captive would be taxed.
Ms. Rizzolo and Mr. Wright are partners in the Tax Department of Sutherland Asbill & Brennan LLP, located in Washington, D.C., and New York, respectively. Ms. Goldner is partner in the Tax Department of Sutherland Asbill & Brennan LLP and located in New York.
- It is subject to the US withholding tax on its Fixed, Determinable, Annual, or Periodical income, which for a captive is typically its investment income, subject to elimination of the tax or a rate reduction on certain types of income under the Code or an applicable income tax treaty.
- The question of whether an entity is engaged in a trade or business within the United States and therefore potentially subject to US federal income tax is a factual one based on all the facts and circumstances. If a company regularly and continuously conducts its substantive business operations in the United States, it may be characterized as engaged in a trade or business within the United States and subject to US federal income taxation under the rules discussed above as well as an additional branch tax. Even if a non-US company is engaged in a trade or business within the United States, if it is entitled to the benefits of a US income tax treaty, it generally would be subject to US federal income taxation only if it conducts such a business through a permanent establishment in the United States. US state and local taxes also may apply to a non-US corporation.
- A non-US company must qualify as an insurance company for US federal tax purposes in order to elect to be treated as a US company. A company that makes such election would be taxable under the Subchapter L rules discussed above.
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